The decision of the UK's First-Tier Tax Tribunal in DSG Retail Limited v. HMRC (published May 2009) attracted significant interest from businesses and their advisers. Not only is it rare for a case concerning transfer pricing to reach the UK Courts, but the decision is important as it deals with the extent to which the UK transfer pricing rules could apply to a non-contractual arrangement between related parties for the indirect provision of business facilities. In addition, the Court considered the appropriate methodology for a transfer pricing adjustment.
DSG is a retailer of electrical goods. Its business involves the practice of selling "extended warranties" at the UK point of sale in respect of the electrical goods. An independent intermediary (ASL) entered into a commission arrangement with the DSG retail sales entity, under which DSG acted as agent for ASL. ASL entered into an insurance arrangement with DISL, the Isle of Man insurance subsidiary of the DGS Group, to insure the whole of ASL's liabilities to holders of warranty contracts. ASL also entered into arrangements with a DSG group company, MSDL, to administer all claims and carry out necessary repairs. Based on actual loss ratios, DISL was extremely profitable. The UK tax authority, HM Revenue & Customs (HMRC), successfully argued before the Court that DISL's profit was generated purely as a result of the series of transactions and that the pricing structure would not have occurred had the parties been operating at arm's length. HMRC contended that, if DISL had been independent, it would have had to pay DSG for the "provision" that made its business possible.
Relevant technical conclusions to be drawn from the decision
Practical impact of the decision
- The term "provision" in the context of transfer pricing is not restricted to a formal or enforceable arrangement.
- OECD guidance is relevant for transactions (including deemed provisions) between UK taxpayers and residents of all jurisdictions, not just treaty countries.
- The UK transfer pricing legislation permits the notional arm's length provision to be different in all its terms, not just price.
- In using any comparable approach, particularly the comparable uncontrolled price (CUP), due consideration must be given to characteristics, such as bargaining power, of the independent parties in the comparable uncontrolled transactions (CUTs).
- Hindsight cannot be used by taxpayers or HMRC in determining whether pricing was set at arm's length; only circumstances and information available at the time can be used.
- In DSG's case, since no true CUPs were available either to the taxpayer or to HMRC, a profit split should be used to calculate the arm's length pricing. This would reward DISL's insurance activities only with reference to its cost of equity based upon a capital asset pricing model (CAPM) approach, and all residual profit should be allocated to DSG in the UK.
(a) UK transfer pricing documentation
In order to satisfy the reasonableness requirement under the UK documentation rules, it should still be acceptable to carry out CUP analyses under existing search strategies. However, CUPs/CUTs must be between parties in situations that cannot be easily differentiated from transactions between the tested parties. Taxpayers should be aware that there will now be greater scrutiny of such analyses if they are ultimately audited in the UK.
In addition, HMRC may now more often expect a profit split mechanism as a methodology for testing the arm's length nature of complex transactions, and particularly for IP transactions. Taxpayers should consider whether analyses using the profit split methodology should be included as best practice in UK documentation. An analysis should be carried out separately from documentation to ensure exposures are understood.
(b) UK transfer pricing audits/litigation
There will typically need to be a greater level of scrutiny of purported CUPs/CUTs that may be specifically presented as support for transaction pricing.
(a) Retail/financial groups selling internally insured (or reinsured) point of sale warranty/insurance contracts in the UK.
Such taxpayers should review their current pricing arrangements in the light of the DSG case to clarify whether they have exposures and, if so, how to deal with these, both for the future but also in terms of tax accounting reserve requirements. The UK banking sector has already been subject to tax audits specifically in respect of internally insured personal protection plans (for example, those sold with mortgages), and material settlements have been negotiated.
(b) All taxpayers where pricing of material or sensitive transactions with the UK is supported by CUPs/CUTs (for example, IP licences).
Taxpayers should consider a review of documentation and comparables analyses in that documentation for exposures arising from potential non-comparability arguments, particularly for tax accounting reserve requirements (for example, FIN48) and in assessing the benefit of the advance pricing agreement (APA) process.
(c) All taxpayers where pricing of material or sensitive transactions with the UK is supported by benchmarking analysis using database comparables (for example cost plus, transactional net margin method).
Again, taxpayers should consider reviewing documentation for non-comparability exposures arising as a result of the DSG decision, again with regard to tax accounting reserve requirements and in assessing the benefit of the APA process.